Indian Economy - Approaching Times

The value erosion and the risk aversion that the global markets have witnessed in the last few days have hit India already. This, however, could just be the beginning. The high inflation, high oil prices and depreciating rupee have reduced the foreign currency reserves to c. USD 300bn. With an external debt of c. USD 221bn this makes the Indian economy quite vulnerable.

As of March 2008
GDP ---------- $ 1232.946bn
Current Account ---------- ($ 37.865bn )
External Debt ---------- $ 221.212bn
Trade Balance ---------- ($ 90.06bn )
As of July 2008
Inflation ---------- 12.36%
Foreign Currency Reserves---------- $ 296.869bn
Table 1: Selected Macroeconomic Data[1]

An initial analysis of the external debt components, however, brings some relief. Only a quarter of the outstanding amount is short term liability (including trade credit of less than one year). Moreover the country’s deposit base at c. USD 760.511bn (87% of the funding source of the Indian banking system) provides a comfortable cushioning. Further, c. 88% of these deposits are with the local banks whose balance sheets are minimally impacted vis-à-vis their foreign counterparts.

As of March 2008
Trade Credit ---------- $ 10.267bn
External Commercial Borrowing ---------- $ 60.019bn
Short Term Debt ---------- $ 44.313bn
Multilateral ---------- $ 39.312bn
Bilateral ---------- $ 19.613bn
Others ---------- $ 45.688bn
Total ---------- $ 221.212bn
Table 2: External Debt[2]

External Commercial Borrowings (ECB) comprise a quarter of the country’s external debt and that is a concern. Typically ECBs have a three to five year tenor and were issued in abundance from 2005 onwards. Thus there could be a refinancing wave about to hit India. Table 3, elaborates on the difficult refinancing conditions. The primary funding source for Indian firms is banks. Regulatory policy which is fighting inflation is constraining liquidity with the domestic banks. Foreign banks have very limited spare capacity at this point in time. In addition, the credit market has widened very significantly[3], implying that the cost of raising money will be much higher. The global capital markets are not conducive to any fresh fund raising ruling out any meaningful equity or public debt issuance. Hence, options for Indian corporates are limited.

As of March 2008
Bank Credit ---------- Rs. 174,566 cr.
External Commercial Borrowing ---------- Rs. 160,221 cr.
Equity capital Markets ---------- Rs. 64,502 cr.
Others ---------- Rs. 148, 202 cr.
Total ---------- Rs. 547,491 cr.
Table 3: Funding Sources for Indian Corporates[4]

With record profits in 2006 and 2007, Indian corprates could have the money to repay any debt maturing in 2008 and presumably in 2009 as well. However, the picture for 2010 maturing debt does not look promising unless the companies either raise the required money at the earliest or extend their debt maturity profile. 2010 becomes a critical year because it is not only India but Asia overall that has a significant redemption schedule coming up in 2010. A recent Morgan Stanley research puts the 2010 redemption figure at over USD 70bn representing 30%+ of the total outstanding Asian corporate debt.

Firms that require funding 10 – 15 months down the line for capex, refinancing or expansion should raise the money now whatever be the cost. On the one hand it will keep them away from competing for funding with everyone else a few months down the line and secondly it will allow them to focus on business opportunities. In short it will put them in a stronger position to capture the upswing in the market.

While everyone is examining their own houses, corporates should also start to recognize the importance of having a diverse and stable investor base on board. This should also extend to having a healthy mix of domestic and foreign banks in their core banking syndicate.

Size, influence and brand no longer ensure longevity. It is a time to go back to basics and tread ahead cautiously.

[1] Source: RBI Website, IMF
[2] Source: RBI
[3] Investment grade credit spreads have widened 100bps in 2 days and there is very little clarity on pricing of illiquid and high yield debt
[4] Source: RBI

LEH Mishap

The last two days have created history. Two of the half a dozen and more “bulge bracket” houses have ceased to exist, US economy is witnessing events that had been considered unconceivable[1] and well the pain is only beginning. The financial world or shall we say the world will never be the same again.

This calamity started as the now infamous sub prime crisis, was fuelled by the increasing oil prices and the increasing inflation sent the world into a credit crunch. While oil is now trading at around USD 92 a barrel, inflation and the credit crunch have shown no signs of abating. Global economy is in a state of shock and there is a wide spread belief that it is only a matter of time that the fire will cross the Atlantic to hit Europe.

How bad will be the impact in Europe? To answer that question one needs a closer look at the macro economic factors, the exposure of individual economies to the housing market and the strength of the local financial system.

Table 1: Macroeconomic and Financial Soundness Data[2]

With the highest forecasted GDP growth rate, the healthiest current account and a relatively low CPI, Germany seems to be the most resilient economy in Europe. The positive net lending[3] and the low mortgage debt to GDP ratio bring comfort that (i) in case of an economic turmoil the economy has some cushion to weather the storm and (ii) the country will not suffer excessively due to a downturn in the housing market.

The situation, however, is completely different for the UK. Not only does the country have an alarmingly high mortgage debt to GDP ratio, it also has a current account deficit and a negative net lending ratio. Further more the UK economy is heavily dependent on the financial services sector and any further impact on the industry will skew the unemployment rate away from the current forecast. Any further increase in unemployment along with the high inflation will cause significant economic turmoil in the country. According to an IMF research, almost 50% of the loans[4] made by UK banks are external loans. This means, that an impact on the UK financial sector will also have presumably far reaching consequences outside the country.

While similar to the UK in terms of high a mortgage to GDP ratio and high current account deficit, Spain probably will not have as much of an impact on the world (given that only c.10% of its loans are external). Moreover, the Spanish banking industry is quite fragmented and supported by solid deposit bases. This in itself could contain some of the impact. However, given the strong emphasis on the construction boom in the recent years, Spain is definitely vulnerable in the current global economic situation.

It is interesting to note that while the 5-year senior USD CDS levels indicate that Germany is indeed believed to be a safer bet currently, the market has not priced in sufficient risk for the UK. On the flip side, the equity markets have penalized Germany relatively more than the UK, despite a Northern Rock and a Bradford & Bingley in the UK.

Table 2: Credit and Equity Market Data[5]

In conclusion, I believe that the doom and gloom might not be as bad as being portrayed. After the US though, it is now UK’s turn to see a changing landscape of the finance industry. With the weaker dominance of these two majors maybe finally the scales have shifted in favour of those who are located eastwards. But does eastwards mean the Continent or does it mean the Far East is yet to be seen.

[1] AIG is trading 92% below its value a year ago as I type and still struggling to raise USD 70bn for survival
[2] Source: Bloomberg, International Monetary Fund, Morgan Stanley Research
[3] Net Lending = Savings - Investments
[4] Loans includes corporate and sovereign debts
[5] Source: Bloomberg